Tuesday, March 30, 2010

Big Swinging Dicks?

Liars Poker, by Michael Lewis, 1990

I’ve spent some time cleaning up the elephant dung from a bond trading floor, so this book strikes home. Lewis makes raw fun of the incompetence and ‘big swinging dicks’ of Salomon Brothers in the 80s, where he trained in New York and worked in London as a bond salesman. It’s just not clear which meaning of the word ‘dick’ we’re talking about. The phrase was used in the film “Wall Street,” a sequel about the recent market crash which is soon to premiere. This book also served as background for Tom Wolfe’s “Bonfire of the Vanities.” Liar’s Poker stands out because most insider books about the ‘market’ are nothing but apologies. This one isn’t. Lewis is coming out with a new book, “The Big Short,” about the short sellers who anticipated the housing bubble and the Collateralized Mortgage Obligation (CMO) crash.

CMO’s – which recently brought down Wall Street - were actually invented in the early 1980s at Salomon Brothers, when Lewis Ranieri developed a way to take a group of mortgages and turn them into a stable bond. A little later, Drexel Burnham’s Michael Milken developed the “junk” bond – the debt of supposedly weak corporations. Milken guessed correctly that a firm that was big enough would not be allowed to go bankrupt, and so the bonds would be paid off. Milken later used junk bonds for hostile takeovers, because ownership of enough debt ensures you have control of a corporation. This is, of course, similar to stock ownership, but right out of left field.

Both these products bloomed during the Reagan era, and through several Reagan recessions, resulting in massive profits and growth for the financial sector, at the same time as the productive economy constricted like a puking stomach. They were examples of the ‘creative’ products American financialization wrought. What is clear throughout the book is the central role played by Fed monetary policies and federal tax and administrative laws in their development. Apologists for the market claim it is the geniuses from the Ivy League who make the money. However, it is changes in government conditions that allow, no, force Wall Street to make it. The era ended with the 1987 market crash – when the only people who made money were the people who shorted equities or who traded bonds.

Lewis was a Princeton and London School of Economics grad who knew next to nothing about being an investment banker, in spite of all his education. What is extraordinary about this is that during this period many, many Harvard, Yale and other Ivy League graduates all wanted to be investment bankers too. The bourgeoisie’s ‘best and brightest’ were attracted to making massive amounts of money quickly. Which shows you the real quality of these people. Lewis himself was not a blue-blood, however, which gave him a bit of perspective. He never confuses gambling with ‘investing.’ He clearly saw how many traders (some babies with only a few months experience) intentionally ripped off customers in the interests of the firm or themselves, knew next to nothing about the products they sold, used (illegal) inside information, and were, as Frank Zappa would say, “only in it for the money.”

Essentially, Salomon sold mortgage bonds to S&Ls, which, after a change in federal law, allowed that once staid industry to turn into extreme gamblers. Because of the massive amount of mortgages in the US, the market seemed endless. Lewis, however, spends little time on the parallel collapse of the S&L industry during this period – hastened by its gambling on CMOs.

This is a hilarious book. Lewis shows how the mortgage-trading department at Salomon was run by fat Italians who never stopped eating, swearing, playing practical jokes and making money. In the good days in the early 80s they were more like a fraternity than a business unit. Ranieri himself came from the back-office at the firm, and then became the head of mortgage trading. He always wore ugly, cheap suits to remind himself and others where he came from. The firm was run mostly by Jewish businessmen – John Gutfruend being the notorious CEO. Unlike other Wall Street‘white shoe’ firms like Morgan Stanley, full of WASPs, Salomon's ethnics specialized, not in equities, but in debt – government, municipal and mortgage. As the slogan kind of went, “Debt is Good.” They had a monopoly on mortgage debt for about 4 years. Salomon eventually weakened itself by not paying its traders a real percentage of what they made (Lewis got $90,000 and still thought he was screwed…), then refusing to get involved in junk bonds – and the traders deserted to every other firm on the Street, creating competition for Salomon.

Lewis quit in 1988, even though he knew he could have made millions if he’d stayed at Salomon. The whole time he was there, he kept notes on events, which formed the basis for this book. Lewis is not an opponent of capital, but he's an honest observer nevertheless.

And I did not buy it at MayDay Books.
Red Frog - 3/30/32010


AA said...

"The Big Short" is already out. There's a review at Alternet:


I seem to recall a more critical review but can't seem to find it at the moment.

I read "Liar's Poker" many years ago. Lewis is a naif. Which is perhaps what makes his books so attractive to lay readers. His is anecdotal writing (as I seem to recall) rather than systemic analysis. But such analysis would require him to be an insider, which he is not. And the book would not be popular.

The financial skullduggery is occurring at an abstruse political, legal, and mathematical level, where the details are simply not understandable by the ordinary American clod. For instance, the use of a suspect quant tool known as the "Gaussian copula." This was used for bundling mortgages into tranches that were then securitised. It's been covered in an article here and there -- maybe one in the NYT.

Ravenmn said...

Yes, Lewis does want to champion the idiot savantts who got ahead of the game and bet on failure. The fact that real people had their lives destroyed is less important than finding a hero to applaud in this idiocy.

Red Frog said...

Lewis is an honest observer. In spite of his obvious theoretical limitations, his inside view is immediate and factual. And he's also funny as hell - which is sometimes more important than several politically-correct manifestos. By the way, Saloman developed securitized mortgage tranches without using a 'quant.'

The "Big Short" I could be equally illuminating - as it counters the idea, presented by both Republicans and Democrats, that "no one" knew the bubble existed, or that it would pop. Even astute market traders knew - it doesn't take a Marxist to understand over-production, financialization and fraud.

AA said...

Well, anyway, here's one pertinent essay on the Gaussian copula:


The whole field of quantitative risk management and portfolio analysis is so much hogwash, in my exceeedingly humble opinion. What is more pertinent, however, and one which I repeatedly stress, is the use of these quant flunkeys and lackeys, these highly-credentialed errand boys, by a financial oligarchy to scam a gullible public, a credulous market. Equations and abstruse mathematical symbols were used to pacify and reassure a public who might otherwise have sensed a gargantuan Ponzi scheme was about to collapse. People like Nicholas Taleb have been doing this -- maybe a few other people.

Incidentally the use of mathematics to con people has a long history. Sasan Fayazmanesh touches upon it here:


AA said...

Apologies for going off on a tangent but here is more on the copula function and exemplifies the arcane crookedness at the heart of the system:


QUOTE Institutional investors have differing requirements. Some want high quality and are willing to accept lower returns. Others want higher returns and will absorb lower quality to get them. With these differences in mind the team split the bundled securities into ten layers, like a torte. Each layer contained a bundle of similar quality mortgages. The layers carried a yield calibrated to reflect the risk entailed. But, there was another problem.

The three lowest quality layers (subprimes) were not easy to sell because the attendant risk was too great for all but the most adventurous investors, like aggressive hedge funds. The team searched for a way to make these subprime bundles palatable to a wide range of investors. And that is where Dr. Li came in.

His solution involved complex mathematics. The technique Dr. Li employed was called the Gaussian copula function. The result was a series of equations that put a percentage figure on the possibility that a large number of subprimes would default simultaneously. Maybe the team thought they understood the mathematics. Maybe the equations looked like a gift from the gods and they just accepted it. In any case Dr. Li's work was incorporated into the subprime bundles.

He had calculated that the simultaneous default risks for the three lowest quality layers were 0.34 percent; 0.49 percent; and 0.88 percent, respectively. With Dr. Li's magic numbers in hand the team came up with a device that could transform subprime mortgage bundles into investment grade securities. It was called a Credit Default Swap (CDS). The CDS was a derivative attached to each subprime bundle. This derivative permitted an investor who bought one of these securities to swap the risk of default with a designated counterparty, such as AIG. The price of the CDS, determined by the market's assessment of the imbedded risk, was the insurance fee paid by the investor.

The newly minted investment grade securities flew out the door. Hundreds of billions worth of them ended up in the coffers of institutions. The CDSs were even more popular. They started trading independently as bets on the likelihood of specific defaults (counterparties still had to pay off in the event of default). Before long $60 trillion worth of them (an amount larger than all the economies of the world combined) were outstanding.

Given the gigantic amount that had been permitted to circulate, even if Dr. Li's percentages had been correct there would have been significant pressure on counterparty equity. But unfortunately Dr. Li's calculations were wrong, disastrously so. The actual percentage of defaults for the bottom three layers turned out to be 48.73 percent; 56.10 percent; and 66.67 percent. The financial consequences were catastrophic, as we all discovered.UNQUOTE

AA said...

And for those who bought these worthless securities, they can now trade it in for taxpayer-funded FHA-backed triple-A securities; see this recent story:


QUOTE It means that Obama's mortgage modification extravaganza has touched-off a gold rush in toxic paper. Subprime securitizations, which had been worth next to nothing, are now the hottest trade on Wall Street. It's a subprime bonanza! The investment sharpies are scarfing up all the crummy MBS they can get their hands on, because they know they can trade it in for Triple A FHA-backed loans when the program get's going. It's another swindle cooked up by Treasury Secretary Timothy Geithner to keep the brokerage clan in the clover. Here's how a Wall Street veteran explained it to me:

"It looks like the investors in securitizations will be swapping underwater real estate for govt-insured paper... I think the scam here is just to provide some cover so the hedge funds and other high net worth individuals can trade their low grade paper for Triple AAA mortgages insured by the FHA at the taxpayer expense."UNQUOTE

Whereas the initial con was in abstruse mathematical language, this one is in abstruse legal and political language. The average American clod, with all the initiative and brains of a factory-farm animal, will continue placidly to chew the cud. Or maybe at some level he will sense something is wrong but he'll be too stupid and too apathetic to find out how he's being shafted.

Red Frog said...

Nice stuff. Yes, I heard about how they are magically changing dirty water into Bordeaux wine.

Red Frog said...

I heard Michael Lewis interviewed on C-Span last night. The new book is based on interviews he did with many participants in recent economic events. He said that 'every citizen needed to know how the sub-prime con' was run, and he wanted people to be 'outraged.' His words. He also made it clear that the 'complexity' of these products was intentional. The subtitle of the book "The Big Short" is "Inside the Doomsday Machine." Cheery stuff.

AA said...

With respect to "outrage," a serious student of late capitalism, of financial capitalism, will part company with Lewis. As people like John Bellamy Foster have been pointing out, phenomena like sub-prime existed because of the demands of the system. Not just because some people were "greedy" and "immoral." By 2005 and 2006 there was no more traction in prime and Alt-A mortgages. The only growth area left was sub-prime. It's the crazy logic of speculative bubbles -- which the US economy has increasingly been based on. Crazy because it was clear that those taking on such mortgages lacked the capacity to repay and were merely stoking an asset bubble that had to explode in the near future. Mathematical equations hid the emperor's nakedness for a while.

Red Frog said...

Lewis quoted in Vanity Fair: "Can you believe the House Republicans have a book group?"
This is because a Republican book group did not attend a Bernanke briefing, but instead went to hear Lewis - for 3 hours. He found them to be incredibly ignorant. Per Lewis:
"And their questions were increasingly: 'Oh my God, Goldman Sachs did what? A.I.G. did what?' They didn't understand it ... At the end, there was smoke coming out of their ears. I thought they were going to go kill someone at the end of it. The minute they started to understand, they were outraged. And I think the more things are explained, the more outraged people will get."

Outrage is cheap, and sometimes mis-directed. You can bet the Repubs will take it out on the working class, not their petit-bourgeois and bourgeois base, no matter what they learned from Lewis.